Look Beyond CEF Discounts

Mike Taggart: Hi, I'm Mike Taggart, director of U.S. closed-end fund research at Morningstar. With me today is Tony Cutinelli, who is a partner and portfolio manager at CLC Management, where he has been investing in a closed-end-fund-focused strategy since October 2002.

Tony, thanks for joining me.

Tony Cutinelli: Thank you, Mike. Thanks for having me.

Taggart: Now, Tony, you've put up what I think is a pretty nice track record, with an annualized performance of just under 9% since inception through your long-short strategy.

I've been wanting to bring you over here, since you are based in Chicago, just so you could help maybe shed some light for our viewers as to how you've put together that track record. So, what's the first step?

Cutinelli: The first step is we do a lot of historical analysis of the discounts and premiums at which closed-end funds trade. There tends to be an average, so a dramatic discount or dramatic premium doesn't necessarily initiate an investment in that security.

We're looking for a deviation from the norm of that average discount or premium to create an interest for us. We'll do screens using Morningstar's database as one of our tools. When we find a significant deviation from the norm, we then go in and do a little more in-depth analysis based on about 10 or 12 different criteria to see if it merits an investment.

Taggart: So, it sounds like you use a relative-discount strategy, which is something that we support in terms of looking at a way of figuring out which funds are what we call overvalued or might be undervalued.

Then, obviously, the time period that you use is different. On our website we provide six-month, one-year, and three-year Z-statistics to figure that out. We consider something that's below negative 2.5 standard deviations to be undervalued and above positive 2.5 to be overvalued.

Cutinelli: We use something very similar to that. The one thing we do overlay is the interest-rate environment at the time; if we're in a neutral-rate, rising-rate, or declining-rate environment, that affects what that relative discount historical is.

Taggart: Now, just like with stocks, if you see a P/E ratio, a PEG ratio, or whatever the metric is, that's kind of the first step. You've mentioned some other steps that you do for your due diligence.

Cutinelli: Right. When they come up on a screen, we'll then go in, we'll look at the earnings power of the fund, whether they are earning their dividend or not, whether there is any undistributed earned income, what the track record of management is, what sector are they in, and what the underlying fundamentals of that sector are.

There is a lot more work that goes into it. It's only after we've gone through that that we make a decision whether it's worthy of an investment. If it is, in our case, we often look to find a similar fund trading at the opposite end, whether it would be overvalued or undervalued as a hedge to the position we put on.

Taggart: Right, because you are long-short, as I mentioned, so you want to take that short position. So, it sounds like just to kind of reiterate this, just because you see something that might look attractive, that might look undervalued or overvalued, when you do the due diligence you aren't just jumping in there and buying it?

Cutinelli: No, it could take quite a while to work through the data or we could find that there is a potential there, but we want to see the discount potentially go out even further, to make us more confident that the risk is priced into the issue.

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Taggart: Absolutely. Every week we publish a list ranked by a three-year Z statistic for different sectors, and we often get a comment of, "Is this really undervalued?" Well, we're not saying to go out and buy it; we're not even necessarily saying that it's statistically undervalued. And we actually put it down in our text whether it's showing up as that way or not, but we just have a list.

But a lot of times, I think, especially, for people who are first seeing the list, they see it and think "Oh wow! This is what I'm going to buy." But they don't realize that there is just some big mess that warrants that kind of a blowout of the discount.

So, now, I know just from our conversations off camera that you look for catalysts as well as part of this process, and there are, obviously, a plethora that you've mentioned, but maybe if we could talk about two specifically: if we could talk about the IPO cycle, and if we could talk about the strength of the distribution.

Cutinelli: Sure. We can start with when there are changes in the distribution, whether it would be positive or negative. An increase in the dividend is usually a very positive sign that the fund is earning its dividend and has excess earnings that are undistributed, so they should be raising it to a level that's maintainable for at least six months to 12 months, in my opinion. You want to see consistency with the dividend and that the management feels comfortable with the portfolio.

So, in earnings, an increase in an dividend is we view positively, a decrease we can view negatively temporarily. A negative cut or a cut in the dividend can create a potential for an investment also if the market overreacts to the dividend cut.

We often view the dividend cut as a better potential investment because of the immediate negative impact it has often pushes that discount so far out that it creates an opportunity. If management has been honest and cuts it to a level that's maintainable, we think that's a great thing for them to do because then we feel confident in the dividend, confident in the earnings, and confident that management has a handle on what they own and what the earnings will be going forward.

So, it works on both sides, as long as it moves the discount. If there is no impact on the discount or premium, it's not really going to create anything, except on the positive side. If they increase it to an amount that suddenly we feel the discount is going to shrink further because of the increase in the yield, that could be a potential catalyst.

Taggart: I have seen this quite a bit in the charts, the news will out that a fund has reduced its distribution and then it shows up on our list as being undervalued because, just like with an equity, it cuts its dividend and it's kind of almost like sell first, ask questions later. Then, obviously, the relative discount strategy is a reversion to the mean. So, you think its overreaction, that the share prices are going to come back up to be more in line with normal.

What about the IPO cycle?

Cutinelli: Well, there is a whole lifecycle to IPOs in the closed-end fund space which I know you've touched on in many articles. The initial point of an IPO is that the security is pretty much immediately overvalued. In the past few years the underwriters, their fee has gone from about 7% down to 4%. So, immediately when the IPO is priced at, let's just say, $20, the net asset value is going to be 4% below that, so it will be $19-$20.

We don't ever really see any reason to invest in an IPO when you're automatically going to be trading at a premium. So, we like to sit on the sidelines for the first year or so or until the fourth quarter of whatever year that IPO has come out in. What we've historically seen is that, as we enter the fourth quarter, if those IPOs are below their offering prices, they are often the first candidates for tax-loss selling. Thus, if that is the case, we'll see the discounts even widen out more in November and early December, at which point we may decide to make some short-term trades in some of these IPOs based on the January effect.

Taggart: Because then you seen the people come back in to them.

Cutinelli: You see a reversion, and again, we do go through all of our criteria that it's not just some IPO that it is not of much interest when only trading at a 6%, 7%, or 8% discount, and we see it widen out 1 or 2 percentage points. It's not going to be enough of an incentive for us to go in there. We kind of go through all the criteria also. If we see some dramatic widening from 10% to 15% in that month or two-month period, that will create an interest for us because it will be easy and clear to see that it's a liquidity issue rather than something internally wrong with the portfolio.

Taggart: Well, most of the 2011 IPOs unfortunately are far underwater this year. So, perhaps, we'll see this play out and hopefully maybe then they will start to come back in December and January. Because, I do hesitate always for investors to buy on the IPO because they're at a premium, but on the other hand it doesn't mean it's a bad fund necessarily underlying or bad team. It's just the nature of the closed-end fund.

So, there have been some, what I think, are pretty interesting funds that have been IPOed this year, and for whatever reasons their price performance just hasn't been there on a total-return basis. So, hopefully, what you're saying, perhaps we will see some tax-loss selling, but then hopefully we'll see them coming back then at the beginning of the year.

Cutinelli: Right.

Taggart: Now Tony, just to end. Now 2008 was a horrible year for a lot of firms and for a lot of funds. Your firm unfortunately was hit kind of hard by the downturn. But what I find interesting are the couple of tweaks that you have made to your strategy with the VIX and with the short-selling. Now with the short-selling, we don't need to get into that because it's kind of technical, but what have you done with the VIX to help alleviate the volatility in the portfolio because this is something I think that individual investors and advisors could actually do in their own portfolios?

Cutinelli: After 2008, when we analyzed what went on in our sector and with all the exchange-traded fund products out there, we were trying to find what would work as the best possible hedge when a crisis, a real crisis hits.

Taggart: It's insurance.

Cutinelli: Right, and with the advent of all these new ETFs, there is an exchange-traded note, the VXX, that we use to utilize as insurance. We found that it would have probably reduced our losses between 70% and 80%, if we would have maintained some kind of VIX insurance through the crisis.

Taggart: This is because discounts for closed-end funds as a whole are negatively correlated with the VIX. So when the VIX spikes, when the fear index spikes, discounts gap down, and so you can mitigate and offset that to a degree.

Cutinelli: Yes, as we saw the discounts go dramatically wider and wider, the VIX continued to explode higher and higher. And what we found, it was the best correlation outside of the closed-end fund world to act as insurance on a closed-end portfolio.

Taggart: Well, we always like to look at risk-adjusted returns and anything to close the volatility. I have read about it and I have seen it. I've actually never met somebody and sat down with them on camera who actually utilizes that in an ongoing strategy. So, I wanted to get that out there, I think it's very interesting.

Cutinelli: Sure. It's definitely something for people to take a look at. It will help out the overall insurance of a portfolio. It's not an individual idea, but it's a great insurance for a portfolio as a whole.

Taggart: It's not a pure hedge, but it still can help.

Cutinelli: Right, exactly.

Taggart: Well, Tony, thanks for the insights. I wish you continued good luck at your firm, and thanks for joining me today.

Cutinelli: Thanks, Mike. Thanks for having me.

Taggart: For Morningstar, I am Mike Taggart. Thanks for watching.